Risk Compliance News September 2011

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_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)

www.risk-compliance-association.com

International Association of Risk and ComplianceProfessionals (IARCP)

1200 G Street NW Suite 800 Washington, DC 20005-6705 USATel: 202-449-9750 www.risk-compliance-association.com

Welcome to the September 2011 edition of the InternationalAssociation of Risk and Compliance Professionals (IARCP)

newsletter

Dear Member,Today we will start from the newFinancial Stability Oversight Council

As established under the Dodd-Frank Act, the Financial StabilityOversight Council (FSOC) will provide, for the first time, comprehensivemonitoring to ensure the stability of the US financial system.

The Council is charged with identifying threats to the financial stability ofthe United States; promoting market discipline; and responding toemerging risks to the stability of the United States financial system.

The Council consists of 10 voting members and 5 nonvoting membersand brings together the expertise of federal financial regulators, state

regulators, and an insurance expert appointed by the President.

Q: What is the Financial Stability Oversight Council and whatwill it do?

A: The Financial Stability Oversight Council (FSOC) has a clear statutorymandate that creates for the first time collective accountability foridentifying risks and responding to emerging threats to financial stability.

It is a collaborative body chaired by the Secretary of the Treasury thatbrings together the expertise of the federal financial regulators, an


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insurance expert appointed by the President, and state regulators.The FSOC has important new authorities to constrain excessive risk inthe financial system.

For instance, the FSOC has authority to designate a nonbank financialfirm for tough new supervision and therefore avoid the regulatory gapsthat existed before the recent crisis.

Closing these gaps in supervision will help minimize the risk of anonbank financial firm threatening the stability of the financial system.

Additionally, to help with the identification of emerging risks to financialstability, the FSOC can provide direction to, and request data andanalyses from the newly created Office of Financial Research (OFR)

housed within Treasury.

Q: How will the FSOC help maintain financial stability?

A: Prior to the crisis, the existing regulatory framework focused regulatorsnarrowly on individual institutions and markets, which allowedsupervisory gaps to grow and regulatory inconsistencies to emergeinturn, allowing arbitrage and weakened standards.

No single entity had responsibility for monitoring and addressing risks to

financial stability, which too often involves different types of financialfirms operating in and institutions across multiple markets andimportant parts of the system were left unregulated.

The Dodd Frank Wall Street Reform and Consumer Protection Act(the Act) addresses these problems through the creation of the FSOC,

which is authorized to:

Facilitate Regulatory Coordination: The FSOC has a statutory duty tofacilitate information sharing and coordination among the memberagencies regarding domestic financial services policy development,


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rulemaking, examinations, reporting requirements, and enforcementactions.

Through this role, the FSOC will help eliminate gaps and weaknesseswithin the regulatory structure, to promote a safer and more stablesystem.

Facilitate Information Sharing and Collection: By statute, the FSOC hasa duty to facilitate the sharing of data and information among themember agencies.

In instances where the data available proves insufficient, the FSOChas the authority to direct the OFR to collect information from certainindividual financial companies to assess risks to the financial system,

including the extent to which a financial activity or financial market inwhich the financial company participates, or the financial company itself,poses a threat to the financial stability of the United States.

The collection and analysis of this data will aid the FSOC and OFR intheir shared goal of removing blind spots in the financial system so thatregulators will be more able to see the entire landscape and be betterequipped to identify systemic risks and other emerging threats.

Designate Nonbank Financial Companies for Consolidated

Supervision: In the run up to the financial crisis, some of the firms whichposed the greatest risk to the financial system were not subject to toughconsolidated supervision.

The Act gives the FSOC with the authority to require consolidatedsupervision of nonbank financial companies, regardless of their corporateform.

Designate Systemic Financial Market Utilities and Systemic Payment,Clearing, or Settlement Activities: The Act authorizes the FSOC to

designate financial market utilities and payment, clearing, or settlement


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activities as systemic, requiring them to meet prescribed riskmanagement standards prescribed and heightened oversightby the Federal Reserve, the Securities and Exchange Commission, or theCommodities Futures Trading Commission.

Recommend Stricter Standards: The FSOC has the authority torecommend stricter standards for the largest, most interconnected firms,including nonbanks, designated by the FSOC for Federal Reservesupervision.

Moreover, where the FSOC determines that certain practices or activitiespose a threat to financial stability, the FSOC may make recommendationsto the primary financial regulatory agencies for new or heightenedstandards.

Break Up Firms that Pose a Grave Threat to Financial Stability: TheFSOC has a significant role in determining whether action should betaken to break up those firms that pose a grave threat to the financialstability of the United States.

Recommend Congress close specific gaps in regulation.

Q: What can we expect from the FSOC?

A: Over the next year, the FSOC will work to establish processes fordesignating nonbank financial companies and financial market utilities,recommending stricter standards, for monitoring and reporting onsystemic risk, and for monitoring the financial system for emerging risks.

The FSOC can help provide a coordination role among the memberagencies to help bring agencies together and to coordinate complexinteragency rulemakings, where appropriate.

The FSOC released an integrated roadmap following its first meeting thatis based on each independent agencys internal planning processes,


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which puts into the public domain timeframes statutory deadlines for keydeliverables.

Q: Who does the FSOC report to?

A: The FSOC provides new accountability to Congress and the Americanpeople to address emerging threats to financial stability and to coordinateregulatory actions to address them.

The FSOC will be held accountable through a requirement that the FSOCreport to Congress annually and that the Chairperson testify on theFSOCs activities and emerging threats to financial stability.

Moreover, the FSOC will report to Congress as appropriate on particular

topics.

For instance, the FSOC is required to conduct four studies in its first sixmonths following enactment, including a report providingrecommendations on implementation of the Volcker Rule.

Q: Will FSOC Meetings be open to the public?

A: The FSOC is committed to conducting its business in an open andtransparent manner.

The FSOC will open its meetings to the public whenever possible. At thesame time, the central mission of the FSOC is to monitor systemic andemerging threats.

This will require discussion of supervisory and other market sensitivedata, including information about individual firms, transactions andmarkets that may only be obtained if maintained on a confidential basis.


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Protection of this information will be necessary in order to preventdestabilizing market speculation that could occur if that information wereto be disclosed.

Accordingly, the FSOC has adopted public transparency policies thatenumerate the reasons that the Chairperson may close a meeting, in

whole or in part.

In any event, the FSOC commits to holding two open meetings each year.In addition, when FSOC Members are asked to vote on a draft of a

proposed or final rule, the FSOC will make those agenda items open tothe public.

Q: How has Treasury been working with other Federal agencies

to form the FSOC?

A: The FSOC will operate under a committee structure to promote sharedresponsibility among the member agencies and to leverage the expertisethat already exists at each agency.

The FSOC will form committees around its various statutoryresponsibilities and core issues that relate closely to systemic risk wheremore than one agency has a significant interest.

The FSOC will require some independent staff to provide advice onstatutory authorities and obligations, and to manage its document flow,records retention, and public records disclosure.

A staff of policy experts, with many detailed by member agencies, willalso be required to help coordinate the work of the committees and,

where appropriate, complex interagency rule makings, to support FSOCfunctions such as designations, and to draft reports to Congress.


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Testimony

J. Nellie Liang, Director, Office of Financial Stability Policy and Research,Financial Stability Oversight CouncilBefore the Subcommittee on Oversight and Investigations, Committee onFinancial Services, U.S. House of Representatives, Washington, D.C.

Chairman Neugebauer, Ranking Member Capuano, and other membersof the subcommittee, thank you for the opportunity to testify on theFederal Reserve Board's role as a member of the Financial StabilityOversight Council (FSOC).

The Federal Reserve is committed to working with the other Councilmembers to advance the objectives that the Congress established for the

Council and, more broadly, to implement effectively the regulatory reformmeasures set forth in the Dodd-Frank Wall Street Reform and ConsumerProtection Act (Dodd-Frank Act).

Financial Stability Oversight Council

The Dodd-Frank Act created the FSOC and charged it with theimportant tasks of identifying and mitigating risks to the stability of theU.S. financial system, among other duties.

The FSOC members represent a number of regulatory agencies thatoversee a broad range of participants in U.S. financial markets.

The Council is composed of 10 voting members and 5 nonvotingmembers.

The Chairman of the Board of Governors of the Federal Reserve System isa voting member.


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I am here testifying on behalf of the Chairman, as the director of theBoard's recently created Office of Financial Stability Policy and Research.

As stated by the act, the purpose of the FSOC is

(A) to identify risks to the financial stability of the United States thatcould arise from the material financial distress or failure, or ongoingactivities, of large, interconnected bank holding companies or nonbankfinancial companies, or that could arise outside the financial servicesmarketplace;

(B) to promote market discipline, by eliminating expectations on the partof shareholders, creditors, and counterparties of such companies that theGovernment will shield them from losses in the event of failure; and

(C) to respond to emerging threats to the stability of the United Statesfinancial system.

In carrying out its duties to mitigate risks, the FSOC is well-placed toaddress risks that do not fall clearly within the jurisdiction of a singleagency.

The FSOC also is expected to monitor domestic and internationalfinancial regulatory developments, as well as to advise the Congress and

make recommendations to enhance the integrity, efficiency,competitiveness, and stability of the U.S. financial markets.

The FSOC has made meaningful progress in a number of areas since theact was passed less than a year ago.

It has taken a number of important steps to promote interagencycollaboration and has established the organizational structure and

processes necessary to execute its duties.


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Importantly, the FSOC's internal organizational structure has beendesigned to leverage the expertise of the member agencies, and to

promote a shared responsibility among the agencies for executing theduties of the FSOC. Special consideration has been given to promotingthe sharing of information to help identify risks that could have the

potential to become systemic, and facilitating coordination among themember agencies with respect to policy development, rulemaking,examinations, reporting requirements, and enforcement actions.

The FSOC's internal organizational structure consists of a DeputiesCommittee, which is composed of staff from all of the voting andnonvoting members, and six other standing committees, each charged

with carrying out specific duties of the FSOC.

The duties of these committees include: identifying nonbank financialfirms and financial market utilities that could pose a systemic risk,making recommendations to financial regulatory agencies regardingheightened prudential standards for financial firms, makingrecommendations to enhance the prospects for orderly resolution ofsystemically important financial firms, collecting data and improvingdata reporting standards, and monitoring the financial system to identify

potential threats to the financial stability of the United States.

The Deputies Committee, under the direction of the FSOC members,

coordinates and oversees the work of the other committees and aims toensure that the FSOC fulfills its duties in an effective and timely manner.

In meeting its responsibilities under the Dodd-Frank Act, the FSOC andits member agencies have completed studies on limits on proprietarytrading and investments in hedge funds and private equity funds bybanking firms (the Volcker rule), on financial sector concentration limits,on the macroeconomic effects of risk retention, and on the economiceffects of systemic risk regulation.


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It also has made progress toward establishing an analytical frameworkand processes to identify nonbank financial firms that could pose a threatto financial stability, including through the issuance of advance notices of

proposed rulemakings on the designation of nonbank financialinstitutions and financial market utilities.

Additionally, the FSOC currently is working on preparing the inauguralFSOC annual financial stability report, scheduled to be publicly releasedlater this year.

As required by the statute, the annual report will discuss major financialand regulatory developments, potential risks to the financial system, andrecommendations to mitigate potential risks.

Implementation of Regulatory Reform at the Federal Reserve

In addition to the Federal Reserve's role as a member of the FSOC, theDodd-Frank Act gives the Federal Reserve other new importantresponsibilities.

These responsibilities include supervising nonbank financial firms thatare designated as systemically important by the Council, supervisingthrift holding companies, and developing enhanced prudentialstandards--including those for capital, liquidity, stress tests,

single-counterparty credit limits, and living will requirements--for largebank holding companies and systemically important nonbank financialfirms designated by the Council.

The Federal Reserve is working assiduously to meet its obligations underthe Dodd-Frank Act.

The act requires the Federal Reserve to complete more than 50rulemakings and sets of formal guidelines as well as numerous reportsand studies.


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We also have been assigned formal responsibilities to consult andcollaborate with other agencies on a substantial number of additionalrules, provisions, and studies.

In order to meet our obligations in a timely manner, we are drawing onexpertise and resources from across the Federal Reserve System in theareas of banking supervision, economic research, financial markets,consumer protection, payment systems, and legal analysis.

Members of the Federal Reserve's staff are working closely with theFSOC and the other regulators to strengthen systemic oversight.

We are assisting the Council in the development of its analyticalframework and procedures under which it will identify systemically

important nonbank firms and financial market utilities and its systemicrisk monitoring and evaluation processes.

We are contributing to numerous studies and rulemakings.

We are helping the new Office of Financial Research to develop potentialdata reporting standards to support the duty of the FSOC to monitor andevaluate systemic risk factors.

We also are meeting regularly with staff of the other FSOC member

agencies to discuss emerging risks to financial institutions and markets.

The Federal Reserve has made some internal changes to better carry outits responsibilities.

Prior to the enactment of the Dodd-Frank Act, we had begun to reorientour supervisory structure to strengthen supervision of the largest, mostcomplex financial firms, through the creation of the Large InstitutionSupervision Coordinating Committee, a centralized, multidisciplinarybody.


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Relative to previous practices, this body makes greater use of horizontal,or cross-firm, evaluations of the practices and portfolios of firms.

It relies more on additional and improved quantitative methods forevaluating the performance of firms, and it employs the broad range ofskills of the Federal Reserve staff more efficiently.

In addition, we have reorganized to more effectively coordinate andintegrate policy development for and supervision of systemicallyimportant financial market utilities.

As the act recognizes, supervision should take into account the overallfinancial stability of the United States, in addition to the safety andsoundness of each individual firm.

Our revised internal organizational structure facilitates ourimplementation of this macroprudential approach to oversight.

More recently, we created an Office of Financial Stability Policy andResearch at the Federal Reserve Board.

This office contributes to the Federal Reserve System's multidisciplinaryapproach to the supervision of large, complex institutions.

It helps identify and analyze potential risks to the broader financialsystem and the economy stemming from, among other things, potentialasset price misalignment, excessive leverage, outsized financial flows,and structural vulnerabilities in financial markets.

In addition, the office helps evaluate policies to promote financialstability.

It is also important that U.S. financial reforms be implemented incoordination with international efforts to establish consistent and


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complementary standards and to ensure effective oversight ofinternationally active firms and markets.

We continue to work actively with our international counterparts onenhanced prudential standards for large financial institutions, to ensurethat efforts to implement the Dodd-Frank Act are well aligned with effortsof the Group of Twenty, the Financial Stability Board, and the BaselCommittee on Banking Supervision.

In closing, the Congress has given the FSOC an important mandate toidentify and mitigate systemic risks.

The Federal Reserve will work closely with our fellow regulators, theCongress, and the Administration to help the FSOC execute its

responsibilities and promote financial stability in the United States.

The U.S. Secretary of the Treasury serves as the FSOC chairman.

Other voting members include the heads of the Office of the Comptrollerof the Currency, the Securities and Exchange Commission, the FederalDeposit Insurance Corporation, the Commodity Futures TradingCommission, the Federal Housing Finance Agency, the National CreditUnion Administration, the Bureau of Consumer Financial Protection, andan independent insurance expert appointed by the President. The latter

two seats are in the process of being filled.

The five nonvoting seats are represented at present by participants fromthe Missouri Department of Insurance, Financial Institutions, andProfessional Registration; the California Department of FinancialInstitutions; the North Carolina Department of the Secretary of State,Securities Division; the Federal Insurance Office; and the Office ofFinancial Research.


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SEC Proposes Private Fund Systemic Risk Reporting Rule

The Securities and Exchange Commission proposed a rule to requireadvisers to hedge funds and other private funds to report information foruse by the Financial Stability Oversight Council (FSOC) in monitoringrisk to the U.S. financial system.

The proposed rule would implement Sections 404 and 406 of theDodd-Frank Wall Street Reform and Consumer Protection Act.

The proposal creates a new reporting form (Form PF) to be filedperiodically by SEC-registered investment advisers who manage one ormore private funds.

Information reported on Form PF would remain confidential.

"The data collection we propose will play an important role in supportingthe framework created by the Dodd-Frank Act and is designed to ensurethat regulators have a view into any financial market activity of potentialsystemic importance," said SEC Chairman Mary L. Schapiro.

Under the proposal, larger private fund advisers managing hedge funds,"liquidity funds" (i.e., unregistered money market funds), and privateequity funds would be subject to heightened reporting requirements.

Large private fund advisers would include any adviser with $1 billion ormore in hedge fund, liquidity fund, or private equity fund assets undermanagement.

All other private fund advisers would be regarded as smaller private fundadvisers and would not be subject to the heightened reportingrequirements.


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Although this heightened reporting threshold would apply to only about200 U.S.-based hedge fund advisers, these advisers manage more than 80

percent of the assets under management.

Proposed Form PF is the result of extensive consultation andcollaboration between staff of the SEC and other FSOC members.

This collaboration followed on earlier work with international regulatorsto conform hedge fund regulatory reporting standards.

The SEC's public comment period on the proposed reportingrequirements will last 60 days.

The Dodd-Frank Act established FSOC for the purpose of monitoring

risks to the stability of the U.S. financial system.

Working with other regulators, FSOC will gather information from manysectors of the financial system for this purpose.

In order to assist FSOC in this process, the Dodd-Frank Act directs theCommission to collect information from advisers to hedge funds andother private funds as necessary for FSOC's assessment of systemic risk.

To implement this requirement, the Commission is proposing a new

reporting form (Form PF) that would be filed periodically by investmentadvisers that are registered under the Advisers Act and manage one ormore private funds. Information reported on Form PF would remainconfidential.

In formulating this proposal, the Commission collaborated with theU.K.'s Financial Services Authority and other members of theInternational Organization of Securities Commissions.

The resulting form is similar in many respects to surveys of large hedge

fund advisers conducted by foreign financial regulators.


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In addition, the Commission consulted extensively with staff representingthe other members of FSOC.

The CFTC is scheduled to vote tomorrow on jointly proposing thesereporting requirements.

If the CFTC approves the joint proposal, private fund advisers that arealso registered with the CFTC as commodity pool operators orcommodity trading advisors would file Form PF to comply with certainreporting obligations that the CFTC would impose.

Proposed Reporting Requirements

Under the proposed reporting requirements, private fund advisers wouldbe divided by size into two broad groupslarge advisers and smalleradvisers. The amount of information reported and the frequency ofreporting would depend on the group to which the adviser belongs.

Large private fund advisers would include any adviser with $1 billion ormore in hedge fund, "liquidity fund" (i.e. unregistered money marketfund), or private equity fund assets under management.

All other private fund advisers would be regarded as smaller private fund

advisers.

The Commission anticipates that most private fund advisers would beregarded as smaller private fund advisers but that the relatively limitednumber of large advisers providing more detailed information wouldrepresent a large majority of industry assets under management.

As a result, this threshold would allow FSOC to monitor a significantportion of private fund assets while reducing the amount of reporting forprivate fund advisers.


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Smaller Private Fund Advisers

Smaller private fund advisers would file Form PF only once a year andwould report only basic information regarding the private funds theyadvise.

This would include information regarding leverage, credit providers,investor concentration and fund performance.

Smaller advisers managing hedge funds would also report informationabout fund strategy, counterparty credit risk and use of trading andclearing mechanisms.

Large Private Fund Advisers

Large private fund advisers would file Form PF on a quarterly basis andwould provide more detailed information than smaller advisers.

The focus of the reporting would depend on the type of private fund thatthe adviser manages:

Large hedge fund advisers would report on an aggregated basisinformation regarding exposures by asset class, geographicalconcentration and turnover.

In addition, for each managed hedge fund having a net asset value of atleast $500 million, these advisers would report certain informationrelating to that fund's investments, leverage, risk profile and liquidity.

Large liquidity fund advisers would provide information on the types ofassets in each of their liquidity fund's portfolios, certain informationrelevant to the risk profile of the fund, and the extent to which the fundhas a policy of complying with all or aspects of the Investment Company


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Act's principal rule concerning registered money market funds (Rule2a-7).

Large private equity fund advisers would respond to questions focusingprimarily on the extent of leverage incurred by their funds' portfoliocompanies, the use of bridge financing, and their funds' investments infinancial institutions.

What's Next

The Commission is seeking public comment on the proposed reportingrequirements.

Comments should be received by the Commission within 60 days after

publication of the proposing release in the Federal Register.


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Basel III News

It is time to welcome the proposal for the Basel III implementation in theEuropean Union: The Capital Requirements Directive 4 (CRD 4).

It is really interesting that the European Union undermines some BaselIII rules in several ways.The CRD 4 is less conservative than the Basel IIItext!!!

The CRD 4 allows core tier 1 capital ratios, under certain circumstances,to be bolstered by items such as deferred tax assets.

It also allows banks to take advantage ofminority interests and holdingsin other financial companies more generously than foreseen under BaselIII.

This is a regulatory arbitrage opportunity for banks with large insurancesubsidiaries.

The European proposal also discusses the refusal of the U.S. toimplement Basel II in all banks, and the consequences of that. In fact,Europe complains that in the States the regulators are not good enough.

The same time, Sheila C. Bair, Chairman, FDIC (Federal DepositInsurance Corporation, USA) said thatthe EA greater tolerance forfinancial leverage by European banks should not be taken as the basis forallowing U.S. banks to operate with excessive leverage. Indeed, I am veryconcerned about the potential for the European banking system tobecome a future source of financial instability, and not just because of the

well-publicized issues about the credit quality of some sovereigns andbanks exposure to the system

Yes, we live in a mad world.

Why a directive?

EU directives lay down certain end results that must be achieved in everyMember State. National authorities have to adapt their laws to meet thesegoals, but are free to decide how to do so.


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Each directive specifies the date by which the national laws must beadapted - giving national authorities the room for manoeuvre within thedeadlines necessary to take account of differing national situations.

Directives are used to bring different national laws into line with each

other, and are particularly common in matters affecting the operation ofthe single market (e.g. product safety standards).

Is it the 4th capital requirements directive?

Yes. The Capital Requirements Directive (CRD) came into force on 1January 2007.

It was designed to establish a common understanding of the Basel IIrules within the European Union (EU) and to ensure the financialsoundness of credit institutions (banks and building societies) andcertain investment firms.

The extent of the financial crisis has exposed unacceptable riskspertaining to the CRD / Basel II rules. According to the IMF estimates,crisis-related losses incurred by European banks between 2007 and 2010are close to 1 trillion or 8% of the EU GDP.

In order to restore confidence and stability in the banking sector andensure that credit continues to flow to the real economy, both the EU andits Member States (MS) adopted a broad range of unprecedentedmeasures with the taxpayer ultimately footing the bill.

In this context, between October 2008 and October 2010 the EuropeanCommission (Commission) has approved4.6 trillion (equivalent to 39%of the EU GDP) of state aid measures to financial institutions of whichmore than 2 trillion were effectively used in 2008 and 2009.

The unprecedented level of fiscal support to banks needed to be matchedwith a robust reform addressing the regulatory shortcomings exposedduring the crisis.


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In recognition of this, the European Commission has already proposedcertain amendments to bank regulation in October 2008 (CRDII) and July 2009 (CRD III).

However, to prevent recent problems from occurring in the future andensure that risks linked to the broader issues of financial instability and

procyclicality are more effectively contained, additional internationallycoordinated changes to the EU capital and liquidity regulation of banksare needed.

So, we have the proposal for the CRD 4. The CRD 4 is an important partof the common framework for the implementation of Basel III in theEuropean Economic Area.

CRD 4 does not limit itself to transposing Basel III. It also improves thegovernance and supervision of banks and investment companies.

In terms of governance, the appointment ofBoard members will have tofulfil new criteria, related in particular to availability (impossibility tocumulate certain functions).

In addition, banks will be required to establish a diversity policy for theirBoard members (encouraging gender equality).

The supervisory authorities must have the means to implement the newrules.

To this end, all supervisors must have power to impose dissuasive finesand sanctions to the banks to ensure compliance with the requirements,in particular in terms of reporting.

According to Michel Barnier, Member of the European Commissionresponsible for Internal Market and Services:


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The European Commission has wanted a proposal which fully respectsthe spirit, the letter, the level of ambition and balance of Basel III.

We are the first region in the world to implement Basel IIIand not onlyBasel II - to thewhole financial sector:

8.200 banks accounting for more than 50% of world banking assets will becovered.

Compare this to some 20 big banks in the US, for which Basel III is notyet fully applicable, and which are currently in the process of transitiontowards Basel 2.5.

Our proposal translates precisely the new requirements of Basel III.

Our proposal includes two interrelated instruments: a directive and aregulation.

Why propose a regulation? Because our objective is not only to transposeBasel III, but also to put in place a Single Rulebook, listing the rules thatare directly applicable.

In contrast, a directive can be transposed differently by the differentMember States.

This was specifically asked for by the European Council in June 2009.

Why this instrument? Because we need the same rules for everybody tobuild a real Single Market for financial services, allowing supervisors toact together in a coordinated way and without any possibility ofregulatory arbitrage.

This is a question of economic efficiency as well as of financial stability.


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If we want the supervisors to effectively control European-wide groups,they should be able do it with the same rules, not 27 series of differentrules.

Common rules do not mean that we do not take into account nationalspecificities and the precise risks faced by each bank.

As such, our regulation includes all the necessary flexibility to allowsupervisors to respond to the risks they identify by setting additionalcapital requirements at the appropriate level.

- Each Member State will be able to set the parameters applicable to somespecific risks (e.g. real-estate credit)

- Each Member State will be able to set the exact level of thecounter-cyclical security buffer according to its own economic situation

- Supervisors will be able to require a bank considered to be more at-riskto hold more of its own capital.

The important thing is that the core requirements, which are not linked toany specific fragility, be the same everywhere.

There is no reason for the core prudential rules to be different in Madrid,

Warsaw, London, Paris, Rome and Berlin.

Any national approach to reinforce bank stability would be totally illusoryin a Single Marketdifficulty faced by one European bank has an impacton the whole sector.

If we do not build stability together, we will live under the illusion ofstability behind outdated borders.


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Why is the Commission proposing a revision of the Capitalrequirements directive?

The financial crisis revealed vulnerabilities in the regulation and

supervision of the (European) banking system.

The package proposed builds on the lessons learnt from the recent crisisthat has shown that losses in the financial sector can be extremely large

when a downturn is preceded by a period of excessive credit growth.

Institutions entered the crisis with capital of insufficient quantity andquality.

To safeguard financial stability, governments had to provide

unprecedented support to the banking sector in many countries.

The overarching goal of the CRD 4 proposal is to strengthen theresilience of the EU banking sector so it would be better placed to absorbeconomic shocks while ensuring that banks continue to financeeconomic activity and growth.

What lessons have we learnt from the crisis?

First and foremost the crisis revealed an absolute necessity of enforcingthe cooperation of monetary, fiscal and supervisory authorities across theglobe. Cross border developments were observed too late, cross borderimpacts were very difficult to analyse.

Secondly, some institutions in the financial system appeared to beresilient and ready to absorb also enormous market shocks.

Other institutions, even with similar capital levels, appeared to be unableto protect themselves.


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The crucial differences between the two were found in: the quality and thelevel of the capital base, the availability of the capital base, liquiditymanagement and the effectiveness of their internal and corporategovernance.

These lessons justified amending the Basel agreement, and accordinglyreplacing the CRD with a new regulatory framework.

Thirdly, cross border failures of international financial groups appearedan insurmountable challenge for nationally accountable authorities; as aconsequence, several banks needed the intervention of the state in orderto stay afloat.

The knowledge that banks could have been resolved, also in a cross

border context,would have changed the balance of power between publicauthorities and banks, with the former having more tools at their disposalthan just the public purse and the bail-out option, and the latter not beingable to enjoy the best of all worlds: privatize gains, socialize losses.

This would have put a dent on bank's risk appetite.

Why did existing rules (including Basel 1/Basel 2) not stop thecrisis from happening?

Basel 1 aimed to build a general minimum base of own funds in everybank; the rule was that 8% of the total balance sheet should be backed byown funds in order to absorb losses that could not be absorbed by itscreditors.

Basel 2 was a response to the observation that the required capital basehad invited banks to seek for business that had a higher expected return

while the inherent higher risk profile did not lead to a higher capitalrequirement.


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So, under Basel 2 banks need to hold more capital for higher risk.The Basel 2 framework was implemented in Europe on 1 January 2008,half a year after the start of the crisis.

Basel 2.5 meant to enhance the main shortcomings of Basel 2 related tothe banks' trading book and complex securitisations.

Basel 2.5 was meant to be implemented from 1 January 2011, but requiresimplementation across the globe.

However, the US was unable to implement on time, which pushed backthe implementation timescale in the EU to 31 December 2011.

On top of the above shortcomings, the following factors also contributed

to the crisis: capital that was actually not loss-absorbing, failing liquiditymanagement, inadequate group wide risk management and insufficientgovernance. These are now included in CRD IV.

How does this proposal relate to the stress tests results released?

They complement each other. The results of the union-wide assessmentof the resilience of EU banks to adverse market developments foreseenunder the 2010 EBA regulation (1093/2010) were released.

The test highlighted that a number of banks needed to strengthen theircapital base to better withstand market turmoil in the short term.

This proposal applies to all EU banks (more than 8,300). It strengthenstheir resilience in the long term by increasing the quantity and quality ofcapital they have to hold.

This makes the EU banking system better able to withstand losses shouldthey materialise, thereby reducing the likelihood of default or need for

public support.


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The proposal also contains provisions on stress tests that strengthen theunion-wide ones.

The proposal for a directive notably states professional secrecy shall notprevent competent authorities from publishing the outcome of theunion-wide stress tests and from transmitting the outcome to the EBA for

purposes of publication.

It also complements the EU-wide stress tests. Indeed, the proposal for adirective states that competent authorities shall carry out annualsupervisory stress tests on institutions they supervise if their supervisoryreviews of individual institutions highlight the need for such tests and theunion-wide ones do not sufficiently address the problems found duringthe supervisory review.

Does the CRD IV proposal fully implement "Basel III"?

The European Commission has actively contributed to developing thenew capital, liquidity and leverage standards in the Basel Committee onBanking Supervision, while making sure that major European bankingspecificities and issues are appropriately addressed.

The Commission's proposal therefore respects the balance and level ofambition of Basel III.

However, there are two reasons why the Commission cannot simplycopy/paste Basel III into its legislative proposal.

First, Basel III is not a law. It is the latest configuration of an evolving setof internationally agreed standards developed by supervisors and centralbanks.

That has to now go through a process of democratic control as it istransposed into EU (and national) law.


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It needs to fit with existing EU (and national) laws or arrangements.

As EU law takes precedence over national law, the Commission'sproposal launches that process.

Furthermore, while the Basel capital adequacy agreements apply to'internationally active banks', in the EU it has always applied to all banks(more than 8,300) as well as investment firms.

This wide scope is necessary in the EU where banks authorised in oneMember State can provide their services across the EU's single marketand as such are more than likely to engage in cross-border business.

Also, applying the internationally agreed rules only to a subset of

European banks would create competitive distortions and potential forregulatory arbitrage.

The Commission has had to take these particular circumstances intoaccount when transposing Basel III into EU law.

Nevertheless, the proposal delivers a faithful implementation of Basel IIIin EU law.

This is important, as consistent implementation of Basel III across the

globe is necessary in order to improve the resilience of the global financialsystem and ensure a level playing field.

What is Europe adding to "Basel III"?

As explained above, the most fundamental change is that, inimplementing the Basel III agreement within the EU,we move from auni-dimensional type of world where you have only capital as a prudentialreference, to multi-dimensional regulation and supervision, where youhave capital, liquidity and the leverage ratiowhich is important,because this covers the whole balance sheet of the banks.


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And even within capital, there is a much cleaner definition and morerealistic targets.

In addition to Basel III implementation, the proposal introduces anumber of important changes to the banking regulatory framework.

In the Directive:

- Enhanced governance: the proposal strengthens the requirements withregard to corporate governance arrangements and processes andintroduces new rules aimed at increasing the effectiveness of riskoversight by Boards, improving the status of the risk managementfunction and ensuring effective monitoring by supervisors of riskgovernance.

- Sanctions: The proposal will ensure that all supervisors can applysanctions if EU rules are breached, for example administrative fines of upto 10% of an institution's annual turnover, or temporary bans on membersof the institution's management body. These sanctions should bedeterrent but also effective and proportionate.

- Enhanced supervision: the Commission proposes to reinforce thesupervisory regime to require the annual preparation of a supervisory

programme for each supervised institution on the basis of a risk

assessment, greater and more systematic use of on-site supervisoryexaminations, more robust standards and more intrusive andforward-looking supervisory assessments

- Finally, the proposal will seek to reduce to the extent possible relianceby credit institutions on external credit ratings by:

a) Requiring that all banks' investment decisions are based not only onratings but also on their own internal credit opinion, and


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b) That banks with a material number of exposures in a given portfoliodevelop internal ratings for that portfolio instead of relying on externalratings for the calculation of their capital requirements.

In the Regulation:

-Asingle rule book: The proposal creates for the first time a single setof harmonised prudential rules which banks throughout the EU mustrespect.

EU heads of state and government had called for a "single rule book" inthe wake of the crisis.

This will ensure uniform application of Basel III in all Member States, it

will close regulatory loopholes and will thus contribute to a more effectivefunctioning of the Internal Market.

The Commission suggests removing national options and discretionsfrom the CRD, and achieving full harmonisation by allowing MemberStates to apply stricter requirements only where these are

a) Justified by national circumstances (e.g. real estate),

b) Needed on financial stability grounds or

c.) Because of a bank's specific risk profile.

How do you ensure an international level playing field?

The financial system is global in nature and it is not stronger than itsweakest link. It is therefore important that all countries implementinternational banking standards, including Basel III.

Following the adoption of the Dodd Frank Act in July 2010, the US ispreparing to implement the Basel international standards.


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The Commission has continuous and constructive discussions with USauthoritiesnotably via the EU-US Financial Markets RegulatoryDialoguesregarding their implementation of the Basel II and Basel IIIagreements in a proper and timely manner.

What are the timelines and implementation in other G20countries?

The Commission proposal follows the timelines as agreed in the BaselCommittee: entry into force of the new legislation on 1 January 2013, andfull implementation on 1 January 2019.

The EU is the first jurisdiction publishing its Basel III based legislativeproposal, but all G20 members committed to doing so in due course and

implement as agreed.

The Commission intends to monitor closely relevant internationaldevelopments in this respect.

In this context, it's worth recalling that unlike some other majoreconomies, the EU is not limiting the application of the Basel III reformsto only internationally active banks, but will apply them across itsbanking sector to cover all banks and in general also investment firms.

What will you do if other jurisdictions do not implement?

The EU has an interest in increasing the resilience of its banking system.As Basel III aims to achieve that objective, it is in principle in our interestto implement it.

While there is always a short term risk ofregulatory arbitrage if onejurisdiction goes further than other jurisdictions, in the longer term it isclearly beneficial as market participants benefit from a stable, safe and

sound financial system.


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Even so, there may be areas where an international level playing field ismore important also in the short run (e.g. the new elements of Basel III).

The Commission is therefore closely monitoring the consistentimplementation of Basel III across the globe and would need to draw allthe necessary conclusions in due time should other key jurisdictions notfollow suit.

Why does the proposal contain two legal instruments? Why alsoa regulation?

The proposal divides the current CRD (Capital Requirements Directive)into two legislative instruments:

1.A directive governing the access to deposit-taking activities and

2.A regulation establishing the prudential requirements institutions needto respect.

While Member States will have to transpose the directive into nationallaw, the regulation is directly applicable, which means that it creates lawthat takes immediate effect in all Member States in the same way as anational instrument, without any further action on the part of the nationalauthorities.

This removes the major sources of national divergences (differentinterpretations, gold-plating).

It also makes the regulatory process faster and makes it easier to react tochanged market conditions. It increases transparency, as one rule as

written in the regulation will apply across the single market.

A regulation is subject to the same political decision making process as a

directive at European level, ensuring full democratic control.


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Last but not least, the proposal marks a thorough review of EU bankinglegislation that has developed over decades. The result is a moreaccessible and readable piece of legislation.

What is the single rule book?

In June 2009, the European Council called for the establishment of a"European single rule book applicable to all financial institutions in theSingle Market."

The single rule book aims to provide a single set of harmonisedprudential rules which institutions throughout the EU must respect.

This will ensure uniform application of Basel III in all Member States.

It will close regulatory loopholes and will thus contribute to a moreeffective functioning of the Single Market.

The Commission suggests removing national options and discretionsfrom the CRD, and achieving full harmonisation by allowing MemberStates to apply stricter requirements only where these are needed onfinancial stability grounds or because of a bank's specific risk profile.

Why is the single rule book important?

Today, European banking legislation is based on a Directive which leavesroom for significant divergences in national rules. This has created aregulatory patchwork, leading to legal uncertainty, enabling institutionsto exploit regulatory loopholes, distorting competition, and making itburdensome for firms to operate across the Single Market.

For example:


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Securitisation was at the core of the financial crisis.

Previous global and EU standards (Basel II, CRD I) addressed some ofthe risks by specific capital requirements (including for all liquidityfacilities).

However, many Member States did not follow, benefiting from atransitional opt-out.

In a fully integrated market such as securitisation, it was easy forcross-border groups to issue their securitisation titles in those MemberStates that opted out rather than in Member States which applied thestandards.

Following the experience with securitisation in the financial crisis, CRDII introduced harmonised rules to tighten the conditions under whichinstitutions could benefit from lower capital requirements following asecuritisation (including a harmonised notion of significant risk transfer).

But several Member States have not transposed this by the end of 2010 asrequired.

The financial crisis has shown that reliable internal risk models areimportant for institutions to anticipate stress and hold appropriate

capital.

However, requirements for, and accordingly the implementation of,internal ratings based risk models vary from one Member State toanother.

As a result, capital requirements for comparable exposures differ, leadingpotentially to an unlevel playing field and regulatory arbitrage.

A tough definition of capital is a key element of Basel III. However,

experience with CRD I has shown that Member States introduced


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enormous variations when transposing the directive definition intonational law.

Even where the requirements of the directive were clear, some MemberStates did not correctly transpose them.

In some cases, the Commission had to open infringement proceedings,taking many years, in order to force these Member States to comply withthe directive.

A single rule book based on a regulation will address these shortcomingsand will thereby lead to a more resilient, more transparent, and moreefficient European banking sector:

-A more resilient European banking sector: A single rulebook will ensurethat prudential safeguards are wherever possible applied across the EUand not limited to individual Member States.

The crisis highlighted the extent to which Member States' economies areinterconnected. The EU is a shared economic space. What affects onecountry could affect all.

It is not realistic to believe that unilateral action brings safety in thiscontext.

If a Member State increases the capital requirements for domesticinstitutions, institutions from other Member States can continue to

provide their services with lower requirementsand at a competitiveadvantage - unless other countries follow suit.

This gives also rise to regulatory arbitrage.

Institutions affected by the higher capital requirements could relocate toanother Member State and continue to provide their services in the

original Member State by means of a branch.


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-A more transparent European banking sector: A single rulebook willensure that institutions' financial situation is more transparent andcomparable across the EU - for supervisors, deposit-holders andinvestors.

The financial crisis has demonstrated that the opaqueness of regulatoryrequirements in different Member States was a major cause of financialinstability.

Lack of transparency is an obstacle to effective supervision but also tomarket and investor confidence.

-A more efficient European banking sector: A single rulebook will

ensure that institutions do not have to comply with 27 differing sets ofrules.

Why is the Commission eliminating the possibility for MemberStates to require institutions to hold more capital?

The EU in general and the euro area in particular have a very high degreeof financial and monetary integration.

Decisions on the level of capital requirements therefore need to be taken

for the single market as a whole, as the impact of such requirements is feltby all Member States.

Financial stability can only be achieved by the EU acting together; not byeach Member State on its own.

For example, if EU capital requirements are set too low, an individualMember State cannot escape risks to financial stability by simplyincreasing requirements for its own institutions.


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Unless other Member States follow suit, foreign institutions' branchescan continue to import risk.

Higher levels of capital requirements in one Member State would alsodistort competition and encourage regulatory arbitrage.

For example, institutions could be encouraged to concentrate riskyactivities in Member States which only implement the minimumrequirements.

Therefore, we need to set the level of capital at a level that is appropriatefor the EU as a whole.

That is why the minimum capital requirements written in CRDIV cannot

be increased by national authorities (e.g. 6% CET 1 instead of 4,5%),unless a specific add-on is justified following an individual supervisoryreview (Pillar 2).

Will Member States still retain some flexibility under the SingleRule Book?

Member States will retain some possibilities to require their institutionsto hold more capital.

For example, Member States will retain the possibility to set highercapital requirements for real estate lending, thereby being able to addressreal estate bubbles.

If they do, this will also apply to institutions from other Member Statesthat do business in that Member State.

Moreover, each Member State is responsible for adjusting the level of itscountercyclical buffer to its economic situation and to protect economy

/banking sector from any other structural variables and from the


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exposure of the banking sector to any other risk factors related to risks tofinancial stability.

Furthermore, Member States would naturally retain current powers under"pillar 2", i.e. the ability to impose additional requirements on a specificbank following the supervisory review process.

What is "Pillar 2"? What do you propose to change?

Pillar 2 refers to the possibility for national supervisors to impose a wide

range of measures - including additional capital requirementsonindividual institutions or groups of institutions in order to addresshigher-than-normal risk.

They do so on the basis of a supervisory review and evaluation process,during which they assess how institutions are complying with EUbanking law, the risks they face and the risks they pose to the financialsystem.

Following this review, supervisors decide whether e.g. the institution's

risk management arrangements and level of own funds ensure a sound


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management and coverage of the risks they face and pose.

If the supervisor finds that the institution faces higher risk, it can thenrequire the institution to hold more capital.

In taking this decision, supervisors should notably take into account thepotential impact of their decisions on the stability of the financial systemin all other Member States concerned.

The proposal clarifies that supervisors can extend their conclusions totypes of institutions that, belonging to the same region or sector, faceand/or pose similar risks.

How will this affect those Member States that have already

decided to go further than Basel III or are planning to do so?

Some Member States (e.g. Spain) have already decided to go above theminimum levels of capital foreseen by Basel III.

Some (e.g. Sweden, Cyprus) have indicated their intention to start doingso.

Others (e.g. UK) have national processes under way that considerrequiring minimum level of own funds above Basel III from parts of their

banking sector, even though the full details of such plans are not yetfinalised.

In some instances, Member States have also decided to introduce morequickly the changes foreseen under Basel III that increase the quality ofcapital as well.

The Commission fully shares the objective of improving the resilience ofthe EU banking system and considers that to do so in a sustainable way

requires a single rule book, level of own funds included, applicable across


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the EU.

Member States are free to anticipate the full implementation of Basel IIIand hence move to the capital requirements foreseen for 1 January 2019already today, should they so wish.

While Member States will not be able to exceed the level of own fundsrequirement set by the proposal, they can use the instruments offlexibility foreseen by the proposal for a regulation and directive, namelythe counter-cyclical buffer to dampen excess lending growth and/orrequire a institution or group of institutions to hold additional capital tocover against particular risks (including financial stability) following asupervisory assessment ("Pillar 2").

What is bank capital?

Capital can be defined in different ways. The accounting definition ofcapital is not the same as the definition used for regulatory capital

purposes.

For banking prudential requirements purposes, capital is not obtainedsimply by deducting the value of an institution's liabilities (what it owes)from its assets (what it owns).

Regulatory capital is more conservative than accounting capital.

Only capital that is at all times freely available to absorb losses qualifies asregulatory capital.

Additional conservatism is added by adjusting this measure of capitalfurther by e.g. deducting assets that may not have a stable value instressed market circumstances (e.g. goodwill) and not recognising gainsthat have not yet been realised.


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What is the capital adequacy requirement?

It is the amount of capital an institution is required to hold compared tothe amount of assets, to cover unexpected losses. In the CRD, this iscalled 'minimum own funds requirement' and is expressed as a

percentage.

Why is capital important?

The purpose of capital is to absorb the losses that a bank does not expectto make in the normal course of business (unexpected losses). The morecapital a bank holds, the more losses it can suffer before it defaults.

If a firm owes more than it owns (its assets are worth less than its

liabilities), it cannot pay its debt and is thereby insolvent. If a bank hasless capital than the requirement amount, supervisors can take measuresto prevent insolvency.

How is it calculated?

It is the value of a bank's capital as a percentage of its risk weightedassets (RWA). The formula is simple: capital / RWA > 8%.

What are risk-weighted assets?When assessing how much capital an institution needs to hold, regulatorsweigh an institution's assets according to their risk.

Safe assets (e.g. cash) are disregarded; other assets (e.g. loans to otherinstitutions) are considered more risky and get a higher weight.The morerisky assets an institution holds, the more capital it has to have.

In addition to risk weighing on balance sheet assets, institutions have to

hold capital also against risks related to off balance sheet exposures such


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as loan- and credit card commitments. These are also risk weighed.

What is the difference between Tier 1 and Tier 2 capital?

Capital comes in different forms that serve different purposes. There aretwo types of capital:

Going concern capital: this allows an institution to continue its activitiesand helps to prevent insolvency.

The purest form is common equity (labelled CET1). Going concerncapital is considered Tier 1 capital.

Gone concern capital: this helps ensuring that depositors and senior

creditors can be repaid if the institution fails.

One example of this kind of capital is institution debt. Gone concerncapital is considered Tier 2 capital.

What was the problem with capital during the crisis?

Banks and investment firms did not all hold sufficient amounts of capitaland the capital they held was sometimes of poor quality as it was notreadily available to absorb losses as they materialised.

To prevent institutions from defaulting, public funds had to be used toprop up institutions.

How do you propose to increase the quality and quantity ofcapital?

In line with Basel III, the proposal strengthens institutions' capital baseby increasing the amount of own funds institutions need to hold and by

restricting what counts as own funds.


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Today, banks and investment firms need to hold a minimum total capitalof 8% of risk weighted assets.

Tomorrow, while the total capital an institution will need to hold remainsat 8%, the share that has to be of the highest qualitycommon equity tier1 (CET1)increases from 2% to 4.5%.

The criteria for each instrument will also become more stringent.

Furthermore, the proposal harmonises the adjustments made to capital inorder to determine the amount of regulatory capital that it is prudent torecognise for regulatory purposes.

This new harmonised definition would significantly increase the effectivelevel of regulatory capital required to be held by institutions.

One unit of Basel II capital is therefore not the same as one unit of BaselIII capital.


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Are you only proposing to increase the former minimum level ofcapital?

No. In line with Basel III, the proposal also creates two new capital

buffers: the capital conservation buffer and the counter-cyclical buffer(see section on capital buffers).

To this new framework may in the future be added capital surcharges forsystemically important banks (see section on capital buffers).

Naturally, on top of these own funds requirements, supervisors may addextra capital to cover for other risks following a supervisory review.

How can institutions increase their capital ratio to meet the newrequirements?

Institutions can increase their capital ratio in two ways:


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Increase capital: An institution can increase its capital by either issuingnew shares and/or not pay dividends to its shareholders, i.e. to retain

profits. These new shares and retained profits become included in itscapital base. Provided they do not increase their RWA, this increases theircapital ratio.

Reduce assets and their risk weight: An institution can also cut back onlending, sell loan portfolios and/or make less risky loans andinvestments, thereby reducing its risk-weighted assets, which has theeffect of - for a given amount of capital - increasing its capital ratio(capital/RWA).

When will these provisions start to apply?

Basel III foresees a substantial transition period before the new capitalrequirements apply in full. This is to ensure that increasing the resilienceof institutions does not unduly affect lending to the real economy (i.e. toensure that institutions do not cut back on lending and investments).

The provisions related to the minimum level of own funds willaccordingly bephased in as of 2013.

The newprudential adjustments will also be introduced gradually, 20%per annum from 2014, reaching 100% in 2018.

The provision to grandfather over 10 years will also apply to certain capitalinstruments in order to help to ensure a smooth transition to the newrules.

Why do you allow Member States to implement Basel III fasterthan foreseen?

Basel III foresees a gradual transition to the stricter standards, with full

implementation as of 1 January 2019.


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The Commission proposal foresees the same transition period but allowsMember States to implement the stricter definition and/or level of capitalmore quickly than is required by Basel III.

The reason is that some Member States have already anticipated thereforms contained in Basel III and it would be inappropriate to artificiallyforce them to temporarily undo these desirable reforms.

Does the proposal depart from the Basel III definition of capital?

Under Basel III, CET1 capital instruments for companies that can issueordinary sharesso-called joint stock companies - may comprise only"ordinary shares" that meet 14 strict criteria.

The proposal does not restrict the highest quality form of capital only to"ordinary shares".

However, it takes the same approach as Basel III by imposing 14 strictcriteria that any instrument would have to meet to qualify, withappropriate adaptation to the criteria for instruments issued by non-jointstock companies such as mutuals, cooperative banks and savingsinstitutions.

This approach focuses more on the substance of a capital instrument than

on its legal form.

With 27 different company laws in the EU, a reference to a concept ofordinary shares would not ensure homogeneity of the instrumentsrecognized in a way that clear minimum criteria for recognition ofinstruments would.

Such a focus on substance builds on the first amendment to the CapitalRequirements Directive (CRD II), adopted two years ago.


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This amendment recognised the fact that some EU institutions issueinstruments other than ordinary shares, the loss absorbency of which canbe equivalent to that of ordinary shares.

By requiring that an instrument has to meet the Basel III criteria, theproposal ensures that only the highest quality instruments qualify as bankcapital.

What are the conditions capital instruments have to meet toqualify as Common Equity Tier 1 instruments?

Article 26 of the proposal for a regulation states that capital instrumentcan only qualify as Common Equity Tier 1 instruments if a number ofconditions are met.

These can be summarised as follows (for full details, see article):

1. They are issued directly by the institution;

2. They arepaid up and their purchase is not funded by the institution;

3. They meet a number ofconditions as regards their classification (e.g.they qualify as capital for accounting and insolvency purposes);

4. They are clearly and separately disclosed on institutions' financialstatements balance sheet;

5. They areperpetual;

6. The principal amount of the instruments may not be reduced or repaidunless the institution is e.g. liquidated.

Moreover, the provisions governing the instruments should not indicate

that the principal amount of the instruments would or might be reduced


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or repaid other than in the liquidation of the institution;

7. The instruments meet a number of conditions as regards distributions(e.g. no preferential distributions,, distributions may be paid only out ofdistributable items, the conditions governing the instruments do notinclude a cap or other restriction on the maximum level of distributions,the level of distributions is not determined on the basis of the amount for

which the instruments were purchased, etc);

8. Compared to all the capital instruments issued by the institution, theinstruments absorb the first and proportionately greatest share of lossesas they occur, and each instrument absorbs losses to the same degree asall other Common Equity Tier 1 instruments;

9. The instruments rank below all other claims in the event of insolvencyor liquidation of the institution;

10. The instruments entitle their owners to a claim on the residual assetsof the institution, which, in the event of its liquidation and after the

payment of all senior claims, isproportionate to the amount of suchinstruments issued and is not fixed or subject to a cap;

11. The instruments are not secured, or guaranteed by any entity in thegroup (e.g. the institution, its subsidiaries, the parent institution or its

subsidiaries, etc);

12. The instruments are not subject to any arrangement that enhances theseniority of claims under the instruments in insolvency or liquidation.

These conditions ensure that only the highest quality capital instrumentsqualify as CET1.


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Why is your proposal potentially recognising any instrument asCommon Equity Tier 1, including silent partnerships, and notordinary shares only?

'Silent partnership' is a generic term covering contracts where a silentpartner is implicated in the operations of another firm by means of acapital contribution allowing the silent partner to share in the profit andloss.

It is a generic term covering instruments with widely varyingcharacteristics in terms of e.g. ability to absorb losses. Whether or notsilent partnerships would qualify as CET1 depend on thesecharacteristics.

To warrant recognition in the highest quality category of regulatorycapital, a capital instrumentsilent partnerships includedmust be ofextremely high quality and must absorb losses fully as they arise.

The 14 criteria for Common Equity Tier 1 capital agreed in Basel III areextremely strict by design. Only instruments of the highest quality wouldbe capable of meeting them.

Provided an instrument met those strict criteria - including in respect of

its loss absorbencythe Commission believes it should qualify asCommon Equity Tier 1 capital.

Why do you propose that minority interests can be recognised tothe extent they are used to meet also the counter-cyclical buffer,and not only the minimum capital requirements and the CapitalConservation Buffer?

Minority interests are capital in a subsidiary that is owned by othershareholders from outside the group.


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They are particularly important in the EU, as EU banking groups oftenhave subsidiaries that are not fully owned by the parent company but haveseveral other owners.

Basel III recognises minority interests and certain capital instrumentsissued by subsidiaries (e.g. hybrids and subordinated debt) to beincluded in the capital of the group only where those subsidiaries arebanks (or are subject to the same prudential requirements) and up to thelevel of the new minimum capital requirements and the capitalconservation buffer.

The proposal recognises minority interests also up to the level of the newcountercyclical buffer, as it would in practice be used to absorb losses

within a group.

Furthermore, it also recognises the importance of the countercyclicalbuffer as an EU macro-prudential tool and removes a potentialdisincentive for regulators to use it.

Why are your proposals on the recognition of hedging (whencalculating amounts to be deducted for investments inunconsolidated financial entities) restrictive?

Basel III allows banks to use hedging to reduce the amount of deductionsthey have to make from capital for investments in instruments issued byother financial institutions.

The rationale is that hedging reduces the losses a bank could make fromchanges in the value of investments that are hedged.

That approach could transfer the risk of holdings for long-terminvestment or trading purposes in financial institutions outside of thebanking sector.


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Firms not subject to a similar requirement for deduction would be likelyto provide hedges to banks for their investments and would not thereforebe required to make a similar deduction.

The proposal addresses this risk by limiting recognition of such hedgingto the trading book only.

The Commission believes there are strong reasons to do so:

First, it is difficult to hedge an instrument that is perpetual and held tomaturity in the banking book.

Second, it limits the extent to which such risk can be shifted to anothersector not subject to the same treatment.

Third it reduces the difficulty of establishing who ultimately bears the riskon investments in financial institutions.

Why do you propose to allow significant holdings in otherfinancial entities like insurance companies to be exempt fromdeduction?

Institutions must hold a certain amount of high quality funds to absorbany significant losses they make in the course of business.

Accountants define capital as the difference between assets and liabilities.

However, the accounting definition does not deal with important risks towhich an institution is subject and has to be adjusted accordingly by bankregulation. Such adjustments include deductions, which reduce theamount of capital that is recognised.

Basel III requires banks to deduct significant investments in

unconsolidated financial entities, including insurance entities, from the


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highest quality form of capital (CET1).

The objective is toprevent the double counting of capital, i.e. to ensurethat the bank is not bolstering its own capital with capital that is also usedto support the risks of an insurance subsidiary.

In the EU, groups that contain significant banking / investmentbusinesses and significant insurance businesses are a common andimportant feature of the banking system.

This so-called 'bancassurance' business model is a key feature of the EUbanking landscape. The EU has a specific legal mechanism, theFinancial Conglomerates Directive (FICOD), to address the risk ofdouble counting of capital across the banking and insurance sectors.

The FICOD is based on the international standards set out by the JointForum and allows consolidation of banking and insurance entities in agroup.

In this context, the proposal allows a more robust and consistent versionof the FICOD approach to continue to be used as an alternative to a BaselIII deduction approach. The fundamental review of the FICOD plannedfor 2012 should allow any further changes required to be made to this EUapproach.

Why will you not require certain Deferred Tax Assets (DTAs) tobe deducted?

Deferred Tax Assets (DTAs) are assets that may be used to reduce theamount of future tax obligations.

Basel III treats DTAs differently depending on how much they can berelied upon when needed to help a bank to absorb losses.Where their

value is less certain to be realised, they must be deducted from capital.


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The proposal clarifies that DTAs that are transformed on a mandatoryand automatic basis into a claim on the state when the firm makes a loss

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Risk Compliance News September 2011

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Transcript of Risk Compliance News September 2011